The market system depends upon the discipline of failure.
This is the basis of dynamic evolution of the economy and is essential to the legitimacy of the market system. When failure occurs, corporate finance has well-developed principles and procedures for bankruptcy and the restructuring of failing firms. We have all seen these procedures in action in the failure of airlines, auto companies, the bankruptcy of nonfinancial businesses both small and large, like Kmart, Texaco, and Converse, Inc. We have seen them in the failure of venture capital start-ups, and even with smaller financial institutions. Well-known individuals — from P.T. Barnum to Walt Disney to Donald Trump — have gone through bankruptcy.
But the discipline of bankruptcy and restructuring has not been applied to the large complex financial institutions (LCFIs) in the recent financial crisis. The inability to apply market discipline to LCFIs is not only unsound; it has forced the citizens of the United States to support them with a great deal of money via bailouts and guarantees.1 When LCFIs are not penalized for failure, it sets a terrible precedent for their future behavior— creating an unhealthy dynamic in which bailouts are assumed and risky behavior is underwritten. Worse still, when society perceives a distance between how individuals and businesses are disciplined, anger and demoralization flourish. The resulting distrust in government makes it even more difficult to fix a broken regulatory system.
The defenders of the treatment of LCFIs appeal to the notion of systemic risk, which is an unclear concept, but suggestive of spillovers from the failure of LCFIs to other parts of the economy. Top management of the LCFIs argues vociferously against regulation of their activities. At the same time, they invoke and amplify the fear of systemic spillovers when appealing to the authorities for bailouts in the throes of a crisis.2 Under the current broken system of regulation of LCFIs, there are no doubt many potential spillovers that could cause harm to the wider economy. Yet many of these spillovers or externalities are either unnecessary or unnecessarily large.
The goal of this chapter is to make recommendations to eliminate the distance between how insolvent LCFIs are treated and how individuals and other businesses are treated when on the cusp of failure, after carefully examining the context in which the resolution authorities cope with a failing LCFI.
The method to achieve the goal is to examine the impediments that stand in the way of the practice of sound corporate finance principles that apply to failure and restructuring of an LCFI, and to recommend structural and legal changes that will remove those impediments.
The Challenge Facing the Resolution Authorities
The resolution authorities have to consider a number of dimensions of cost when resolving an insolvent financial institution in order to impose the least cost on society. There are several dimensions to consider when looking at that cost:
a. Costs that spill over onto sectors or regions of the economy whose credit allocation depend upon the specific LCFI that is failing. (Direct Spillovers)
b. Financial contagion, those costs created by spillovers to other financial firms with exposures to the firm being restructured. These firms, in turn, harm the real economy through the weakening of the credit allocation process. (Financial Spillovers)
3. The costs of the precedent this resolution example sets when it becomes imbedded into LCFI management expectations about the incentives they will face in the future. (Moral Hazard)
4. Costs associated with how the burden of the bailout/restructuring influences the public’s trust in government. (Reputation of Government)
The resolution authorities are entrusted by the public to consider all of the tools of resolution to minimize the cost to society when an LCFI fails. (See Diagram 1) When this is done well — when burdens are shared fairly and in a way that is mindful of all of these costs — the government’s reputation is not tarnished.3
The principles of proper resolution of a failed corporation are nothing new.4 They include:
For most businesses, including smaller financial firms and nonfinancial corporations — even those that garner public assistance — this has largely been the process and the practice. Businesses like airlines, along with hundreds of small banks, are handled according to the tried and true criteria.
The LCFIs clearly were not handled in the traditional manner, revealing U.S. government reluctance to apply the known principles of proper resolution, including the wiping out or dilution of common equity or the firing of the LCFI top management that failed in their responsibilities and imposed upon the taxpayers.
What costs deterred the resolution authorities from restructuring the LCFIs in the same way that any other corporate failure is handled? What impediments to credible resolution can be removed so that both policymakers and officials treat a LCFI in the same manner as any other failing corporation? If these obstacles cannot be removed, then society must either 1) regulate LCFIs much more aggressively or; 2) Break them up so that the authorities no longer fear restructuring them.
Credible resolution of LCFIs is necessary to restore the legitimacy of the market system of discipline in the United States and around the world.
Obstacles to Resolution of LCFI
Creating a credible resolution regime requires removing the impediments to resolution of an insolvent LCFI when it is on the doorstep of failure. In what follows, we will address the key impediments that push policy makers to engage in forbearance5 when they should be restructuring the LCFI. The primary obstacles are:
In what follows, each of these impediments to credible resolution is discussed, along with available means to remove the obstacles that induce the authorities to adopt a strategy of forbearance for an insolvent LCFI.
Financial Contagion an Obstacle to Credible Resolution
Many proposals for financial resolution set out principles and action guidelines that are based on the vision of resolving one isolated troubled institution. Yet in practice, when an LCFI is in danger of insolvency, many other financial institutions will also likely be fragile and on the threshold of insolvency. The difficulties are compounded when the cross-exposures between these institutions are substantial. Undeniably there were marked differences in the quality of management across the large firms, but if the question “Are you solvent?” were posed to a chief financial officer at many, if not all of the 9 largest U.S. firms in 2008, the officer would have been forced to reply with a contingent statement like, “It depends upon how the other 8 are resolved and what action the government takes.” When one considers the challenge of 2008 and early 2009 in the U.S., it is very clear, from pre-Bear Stearns failure to the decisions to forbear when Citigroup and Bank of America’ equity capitalization were dwindling, that the context to evaluate resolution was one where a constellation of LCFIs were all in jeopardy together.
When firms are so intricately intertwined, resolution authorities are tempted to avoid action. They are likely to fear that a proper restructuring of any one LCFI’s liabilities may just transmit the losses to other LCFI and take other financial institutions into insolvency. Firm A’s losses, once realized, lead to a write-down of its exposures on the balance sheet of Firm B. If they have large cross-exposures, that may make Firm B insolvent, too.
Fear of financial contagion on the part of authorities, coupled with the political power games that the LCFIs play to influence the management of crisis episodes, inhibit timely, credible and cost-effective resolution of failing financial institutions. Three recommendations for reform to address this challenge are:
Complex, Opaque and Mark-to Model Derivatives As an Obstacle to Credible Resolution9
The recent crisis in the U.S. centered on the collapse of the housing bubble and the role of leverage, off balance sheet exposures, and complex OTC derivatives. Chapter (8) on off balance sheet reform and Chapter (9) on derivatives market reform address the structural remedies that are required to restore integrity and transparency to these dimensions of our financial system that directly involve LCFI. For credible resolution, I believe that proper derivatives reform, given the sheer size of derivative markets and the extent to which they constitute a large portion of the cross exposures between financial firms, must be done to render these exposures both transparent and simplified. A resolution authority cannot function with confidence when the spider web of exposures of an LCFI is opaque, complex and not properly valued.
America cannot end Too Big to Fail without derivatives reform. It is the San Andreas fault of the global financial system.
The use of mark to model accounting methods for OTC derivatives, particularly CDOs and the various concoctions of remixed CDOs, did not prove to be a reliable guide to their value in the marketplace. As a result, the value of assets and the resulting measures of firm capital adequacy were rendered invalid and subject to marked discontinuities in price. They gave no guide to the value of assets or the value of the firms holding them. When a LCFI is in trouble — and there are substantial holdings of complex and opaque OTC derivatives on the balance sheets of all of the LCFI firms — resolution authorities have difficulty unraveling the spider web of exposures and valuing them properly.10 A roadmap of exposures, both on the asset and liability side of the balance sheet, along with the valuation of those exposures, is key to understanding the implications for systemic risk in an LCFI resolution. Unfortunately, it is easy to understand why resolution authorities could be induced to forbear rather than resolve an LCFI when they have no clarity about its structure and patterns of exposures. In such a circumstance, it may be easier to incur the risk that the insolvent LCFI’s balance sheet could continue to deteriorate. Simplifying derivatives — and making them trade on exchanges where there are real prices, and real margin set asides — clears the fog that currently surrounds the roadmap of exposures of an LCFI in danger of failing. It also gives authorities greater confidence in resolving the LCFI at least cost to the taxpayers.
These significant policy changes will be resisted, inevitably. A LCFI with a lucrative derivatives business benefits from the profit margin in complex derivatives. It also gains from customers’ inability to discern their fair value when compared with simple transparent exchange traded instruments. The complexity of a derivative can deter competitive imitation and support profitability. It has been estimated that the 5 largest OTC derivatives dealers in the United States (who are expected to earn more than 35 Billion USD from OTC derivatives in 2009) would lose 15 percent or more of those earnings if they were forced to clear them. They would lose even more when forced to trade on an exchange. Loss of earnings of more than six billion USD constitutes substantial impetus for those firms to resist proper reform. That is a socially tragic — the firms do not calculate the social costs associated with a riskier, more opaque and un-resolvable financial system that depends upon the taxpayer to bail it out in times of stress. Compounding the problem, that very prospect of taxpayer support tends to subsidize and engender overuse of these OTC derivatives that are created around the “OTC marketplace hubs” of the LCFIs.
Finally, it is important to comment on the specific role of credit default swap derivatives in the difficulties of credible resolution. Because naked CDSs11 are permitted, and because they have been an unregulated segment of the market, the resolution authorities find it nearly impossible to comprehend the roadmap of contingent exposures that are triggered when a restructuring of a LCFI takes place. In the CDS market, Firm A can buy or write a CDS on LCFI Firm B with counterparty Firm C. The resolution of Firm B can then send one of the others, A or C, into jeopardy — and the authorities have little or no way of anticipating that consequence. As a result, the entire structure of the CDS market needs to come out of the dark to restore market integrity. For credible resolution, it is key to eliminate resolution authorities’ fear of unforeseen side effects that result from the “credit events” created by LCFI resolutions. We need comprehensive reporting of CDS positions to examiners and to a systemic risk regulator. We also need to confine LCFIs to using CDSs to insure a specific risk, thus prohibiting them from so-called naked buying of CDSs. These changes must be a part of derivatives reform if we are to restore market integrity.12 LCFIs sit in a delicate position adjacent to the public treasury. That is why they should not be permitted to engage in the high intensity leveraged speculation that naked CDS positions offer.
Legal Aspects of Credible Resolution13
We must enact legislation to create resolution powers for the authorities that pertain to financial services holding companies, insurance companies and bank holding companies that would allow them to undertake prompt corrective action in response to an impending insolvency of one of these organizational firms in the event that it was considered a “systemic risk.” This should be done instead of proceeding under the traditional Bankruptcy Code or, in the case of registered broker dealers, the Securities Investor Protection Act (SIPA.14 The legislation should be designed to give the authorities an array of tools that the FDIC has with regard to a bank but does not have the right to exercise in the larger universe of financial institutions. The law should allow resolution authorities to utilize the tools that are available to the FDIC under the FDI Act. These include conservatorship, bridge banks, various forms of open bank assistance, liquidation, or assisted purchase & assumption.15
There are many reasons that new resolution powers could create lower-cost bailouts, cause less systemic disruption, and permit authorities to be more confident in resolving an LCFI. First, a holding company may have solvent subsidiaries that could be sold off as going concerns and preserve value under the bridge bank structure that the FDI Act provides for. Under the Bankruptcy Code, this is a more cumbersome and lengthy process.
In addition, there is a class of exposures referred to in the law as Qualified Financial Contracts (QFC) that include certain swap agreements, forward contracts, repurchase agreements, commodities contracts, and securities contracts, and, importantly, derivatives contracts. They are not subject to the “stay” put on creditors at the time of insolvency that stop them from seizing assets. As a result, these “safe harbored” contracts can be closed out promptly. In periods of extreme market-wide stress, when many LCFIs are in jeopardy, the ability to transfer to a bridge bank or to place the QFCs with a going concern is likely to insure that a myriad of counterparties would not simultaneously close out their QFCs, thus igniting a distress sale in markets that would lead to extreme declines in prices. This, in turn, could feed back onto the balance sheets of the LCFIs and amplify financial stress leading possibly to further insolvencies.16
Advocates of giving derivatives QFI status argue that subjecting derivatives to the “stay” would lead many dealers who run a hedged derivatives book to take abrupt action when one side of that hedge entered into the bankruptcy process in order to rebalance their risk exposure. This could also lead to disruptive market behavior.
The entire legal structure surrounding derivative instruments, their priority in the event of insolvency, and the incentives created by making them QFIs to foment the use of derivatives relative to underlying securities, is a foundation stone in the architecture of the marketplace. The large cross-exposures between LCFIs that make it so difficult to resolve them without exacerbating financial contagion are fostered by making derivatives senior to other elements of the capital structure. The granting of QFI status to derivatives may have inspired a much more heavily-intertwined set of intra LCFI exposures than would otherwise be the case. While there may be some benefit from “netting” QFC derivative contracts in an insolvency and resolution during a closeout, it also appears that allowing long dated derivatives that are a close substitute for senior elements of the capital structure to “leap frog” to the top of priority leads to greater reliance on instruments that are currently poorly supervised and regulated. The risk of financial contagion must be diminished to permit credible resolution of LCFIs. Seen in that light, it may be necessary, as recommended earlier in this chapter, to put position limits on the cross-exposure between LCFIs to offset the incentives created by granting QFI status to derivative instruments.17
In summary, the legal creation of a resolution authority giving powers akin to those of the FDIC under the FDI Act — so that resolution authorities can treat systemically important financial organizations like the bank holding companies and financial services holding companies, insurance companies, and mega sized hedge funds like the FDIC treats banks — aids the efforts to remove the obstacles to credible resolution of LCFIs. It is helpful to have proper powers, but nowhere near sufficient to enable the resolution authorities to use them when faced with an LCFI in distress.
International Impediments to Credible Resolution
Another challenge that deters officials contemplating the resolution of impaired LCFIs is their global presence. The LCFI often has a myriad of affiliates, branches and subsidiaries that inhabit a broad array of regulatory, supervisory and legal regimes around the world. Some of the affiliates are likely to be unregulated. This situation compromises the quality of information that the resolution authority is likely to have about the LCFI. It obscures the roadmap of exposures abroad and potential systemic spillovers.
There are several obstacles to obtaining a high quality portrait of the LCFI and its international positions and exposures. First, national supervisors tend to be very proprietary about sharing information. This is particularly true in times of crisis, when protecting the solvency of home country firms becomes paramount. Second, international supervisory regimes are quite heterogeneous with regard to the quality and frequency of information generated and reported. Third, there are many unregulated segments in the international marketplace. Fourth, some nations have secrecy laws, and some authorities are quite unwilling to share information with foreign authorities for fear of inappropriate leaks of proprietary information that is the essence of a home country firm’s strategy and profitability.
Supervisors face a formidable set of challenges in developing a clear picture of the international context that surrounds a troubled LCFI. We recommend that the following challenges be met to inform and empower the resolution authorities and allow them to resolve a failing LFCI without unforeseen global consequences. The Resolution Authority needs:
Fortunately, these challenges have been widely researched and discussed by a number of working groups within the Bank for International Settlement’s Basel Committee on Bank Supervision Cross Border Bank Resolution Group, the G20, the Financial Stability Board (formerly Financial Stability Forum), and the IMF and World Bank.18, 19 But the recommendation to invest in these systems to provide the authorities with information has yet to be emphatically embraced by political leaders.
A second impediment to resolution that emanates from the global reach of LCFIs is the difficulty of sharing burdens in credit restructuring across the different legal bankruptcy/resolution regimes in the different countries where the affiliates of the LCFI operates.20 We have reached a time when the market for these behemoths is worldwide, and only a resolution regime that can treat creditors comparably, regardless of location, is sensible. The regime must be created to contribute to the credible ability of national resolution authorities to resolve and restructure LCFIs and require market participants who invest in them to bear the appropriate risk.
Harmonization of resolution regimes across the G20 is important for two reasons:
Detection of Insolvency
Once a credible resolution regime has been established, minimizing the taxpayer burden depends upon early detection of impaired institutions. The same information requirements that alleviate the fear of resolution authorities are also necessary to develop contingency plans for insolvency just as the LCFI crosses that line. The FDIC has a regime requiring prompt corrective action after several stages of warning indicators are breached to protect taxpayers and the other members paying into the deposit insurance fund from incurring the costs of a deeply insolvent firm.
To achieve early detection, the information requirements include the international challenges discussed, and also depend upon the real pricing of assets. Real pricing of assets depends upon simple and transparent positions that are readily traded. The earlier sections of this report on both off-balance sheet entities and on derivatives reform, which emphasized the benefits of simple transparent assets in assisting market function, monitoring and credible resolution, also benefits the process of preventing deep losses through early detection. The practice of mark-to-model on complex derivatives tends to be used to overstate the value of assets, and, as a result, the value of the capital of the firm. It thereby increases the risk that insolvency will not be detected promptly. The experience of the crisis of 2007-8 showed complex custom OTC derivatives to be subject to large discontinuous changes in reported value that often constituted the difference between full capital adequacy and insolvency.21 The revaluations occurred abruptly and the reports to examiners were far behind the curve in reporting real valuations. Similarly, the sudden reappearance of “liquidity puts” climbing back onto balance sheets from off balance sheet structures such as Structured Investment Vehicles (SIV) and Conduits lead to market deteriorations in capital from one day to the next. The requirements of high frequency reporting, transparent, simple and frequently valued assets based on real transacted prices, are imperative to early detection of an impaired condition at the firm. Chapters 8 and 9 on off balance sheet reform and the proper structure of derivatives markets address these issues in detail. In light of the burden borne by taxpayers in the recent crisis, there is absolutely no excuse for perpetuating market structures that continue the risks society bears because of opacity.
It is characteristic for the resolution authorities to request complete discretion in responding to the challenges of a financial crisis. Yet when they appear to engage in actions that do not seem to protect the people they were elected/appointed to represent, the question of enacting rules that constrain their methods of resolution begin to look more palatable and/or necessary. In this respect, rules that mandate dilution, if not the wiping out of equity of the impaired LCFI; use of creditor restructuring of debt into equity before any taxpayer money can be touched; mandatory haircuts on Qualified Financial Contracts of up to 15 percent; and mandatory resignation/firing of top management along with potential claw-backs of deferred compensation, can all serve to protect taxpayers. They can also deter top management from crossing into the zone where they depend upon financial support from the public treasury. In a world where money politics, campaign contributions, and lobbying are rampant, we cannot rely on a cops-and-robbers regulatory regime and the willingness of the financial cops to impose pain upon the powerful and wealthy members of the financial sector. It may be better to enact into law deterrent policies that inform creditors, counterparties, management, and stockholders that they will pay a price — with certainty — in the event of insolvency.22
The debate on rules versus discretion in economic policy-making is applied in many realms. Tying the hands of officials can make expectations of outcomes binding and make the deterrent to excessive risk taking more credible. Given the scale of resources involved, the incentives of LCFI and their top management to lobby and fund political candidates to appoint their favorite crony regulators are enormous. When the policy discretion of a Treasury Secretary, Fed Chairman or FDIC Chairman is diminished by the introduction of mandatory rules of resolution, it takes some of the energy out of the potential political “payoff”. Your favorite crony can no longer alleviate the pain of failure on your behalf. A rules-based regime at the margin also discourages that unseemly and unproductive investment of social resources into lobbying to influence government policy to garner superior private returns.23
It is bad policy to be induced to forbear with the LCFI and then subject society to the impaired credit and aggressive practices of desperate insolvent financial institutions whose fear of being put out of business drives them to impose abusive fees, 30 percent interest rates on credit cards, and block housing foreclosure modification to hide their fragile condition for prolonged periods of time. The economy can regain strength if it is not forced to bear the burden of waiting for the balance sheets of LCFI to be rebuilt by the resources they extract from all of us in a long run of forbearance.
Our society, both in the United States and in other major countries, has yet to come to grips with the challenge that these LCFIs pose to the integrity of our system. It will take substantial resources — albeit small in compared to our losses in the recent crisis — to invest in high frequency, comprehensive and global information gathering for the supervision and regulation of LCFIs.
We must undergo a substantial change in social norms to recognize the legitimacy of demands from well-paid examiners and supervisors to get the information from financial firms that are necessary to govern our financial system. The firms are not doing the nation a favor. Their compliance is compulsory and laws have to be enforced.
We must also summon political will. It will take formidable leadership to pass international agreements for coordination of crisis response, mandate information sharing, and make agreements to harmonize resolution regimes across countries.
Many elements of a healthy design of the domestic and international financial system have been developed, refined and were clearly understood by experts on finance and markets long before this crisis of out of control markets erupted in 2007-8. The design of proper reforms is not too complex to understand. It is not beyond comprehension. The primary ingredients, as outlined in this report, are well understood. They are essential to the confidence and integrity of American capital markets. It is well beyond time to enact them and to enforce them. Finance is a means to serve the economy and society. It is not an end in itself.
Rob Johnson is Senior Fellow and Director of the Project on Global Finance at the Roosevelt Institute; he also serves on the United Nations Commission of Experts on Finance and International Monetary Reform. Previously, Dr. Johnson was a managing director at Soros Fund Management and a managing director at the Bankers Trust Company. He has served as chief economist of the U.S. Senate Banking Committee and was senior economist of the U.S. Senate Budget Committee.
The views expressed in this paper are those of the author and do not necessarily reflect the positions of the Roosevelt Institute, its officers, or its directors.